Lecture 21.docx

Lecture 21
Interest rates in a small open economy
o Open economy: allows goods, services, and capital to flow across borders freely
o Small open economy (SOE): not large enough to affect world interest rates or
world prices
*The United States is one of the big open economies out of the four in the world.
o Perfect capital mobility: full access to world financial markets
o Canada is an example of Small open economy (SOE)
o Interest rate parity: in theory, the real interest rate (in Canada) should equal real
interest in world financial markets
r = r^w
Interest rate parity is not always perfect for two reasons:
1) Risk
2) Tax treatment
Model of a s